PDF Chapter 03 - Basic Annuities

Chapter 03 - Basic Annuities

Section 3.0 - Sum of a Geometric Sequence

The form for the sum of a geometric sequence is: Sum(n) a + ar + ar 2 + ar 3 + ? ? ? + ar n-1

Here Note that

a = (the first term)

n = (the number of terms)

r = (the multiplicative factor between adjacent terms)

rSum(n) = ar + ar 2 + ? ? ? + ar n

and therefore

a + rSum(n) = a + ar + ar 2 + ? ? ? + ar n-1 + ar n = Sum(n) + ar n.

Solving this equation for Sum(n) produces

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(r - 1)Sum(n) = a(r n - 1).

Therefore Sum(n) =

a(1-r n) (1-r )

=

a(r n-1) (r -1)

if r = 1

na

if r = 1

We will refer to this formula with the abbreviation SGS.

Example

100 + 1002 + 1003 + ? ? ? + 10030 = 100(1 - 30) (1 - )

So

,

for

example,

if

=

1 1.1

,

then

the

above

sum

is

100(1.1)-1(1 - (1.1)-30)

(1 - (1.1)-1)

= 942.6914467

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Section 3.1 - Annuity Terminology

Definition: An annuity is intervals of time.

Examples: Home Mortgage payments, car loan payments, pension payments.

For an annuity - certain, the payments are made for a fixed (finite) period of time, called the term of the annuity. An example is monthly payments on a 30-year home mortgage.

For an contingent annuity, the payments are made until some event happens. An example is monthly pension payments which continue until the person dies.

The interval between payments (a month, a quarter, a year) is called the payment period.

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Section 3.2 - Annuity - Immediate (Ordinary Annuity)

In the annuity-Immediate setting Generic Setting The amount of 1 is paid at the end of each of n payment periods.

0 1 2 ... n-1 n Time

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Payment 01

The present value of this sequence of payments is an| an|i + 2 + 3 + ? ? ? + n

(1 - n) =

i

(1 + i)-1 1

because 1 - = i(1 + i)-1 = i

where i is the effective interest rate per payment period.

Payment 01

0 1 2 ... n-1 n

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Viewing this stream of payments from the end of the last payment period, the accumulated value (future value) is

sn| sn|i 1 + (1 + i) + (1 + i)2 + ? ? ? + (1 + i)n-1

1 (1 + i)n - 1 =

(1 + i) - 1

by SGS

Note also that = (1 + i)-1 implies (1 + i)nan| = (1 + i)n( + 2 + ? ? ? + n) = (1 + i)n-1 + (1 + i)n-2 + ? ? ? + 1 = sn|

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Payment i1

Invest 1 for n periods, paying i at the end of each period. If the principal is returned at the end, how does the present value of these payments relate to the initial investment?

0 1 2 ... n-1 n Time

1 = i + i2 + ? ? ? + in + 1n = ian| + n.

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A relationship that will be used in a later chapter is

1

i

sn| + i = (1 + i)n - 1 + i

i + i(1 + i)n - i = (1 + i)n - 1

i

=

1-

1 (1+i )n

i

1

= 1 - n = an|

Example Auto loan requires payments of $300 per month for 3 years at a nominal annual rate of 9% compounded monthly. What is the present value of this loan and the accumulated value at its conclusion? ---------

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